Euro Area Financial Fragmentation and Bond Market Stability

This paper investigates the phenomenon of financial fragmentation within the euro area and focuses on its implications for bond market stability. A three-step approach is used to assess the sensitivity of credit risk premiums to identified global risk shocks, distinguishing between regimes of higher and lower fragmentation. First, a time-varying indicator of euro area financial fragmentation is constructed on the basis of a principal component analysis of sovereign yield changes. The indicator reflects the extent to which yields across different country groupings—often characterized by differing structural and financial market conditions—move in opposite directions. Second, we construct a series of identified global risk shocks using a signrestricted Bayesian vector auto-regression model applied to a set of financial market variables. Third, we assess bond market stability/fragility in terms of the responsiveness of credit risk premiums to global risk shocks, using a non-linear panel local projections method, distinguishing between regimes of higher and lower fragmentation. We find that during times of elevated fragmentation, both sovereign CDS premiums and corporate option-adjusted spreads react more strongly to a given global risk shock. This elevated sensitivity appears across both country groupings, suggesting that in the higher-fragmentation regime, bond markets are more vulnerable throughout the euro area. These findings indicate that efforts to strengthen financial integration could contribute to greater bond market resilience.